Is the Market Top-Heavy?

The top-heavy outperformance of the FAANG stocks is not a historical anomaly, but history shows that they are likely to be tomorrow’s underperformers.

The tremendous dispersion of returns in the stocks within the S&P 500 over the past several years has brought great attention to the largest companies in the index. As of the end of August 2020, the six largest listed stocks, Apple (7.3%), Microsoft (5.9%), Amazon (5.0%), Facebook (2.4%) and Alphabet (Class A shares 1.7% and Class C shares 1.7%), made up 24% of the market cap of the index. They became the largest stocks because of their strong performance over the prior 10 years. In addition, year-to-date through August, while the S&P 500 Index returned 10%, those five stocks returned 49%, while the remaining stocks in the index returned -3%.

Even more compelling is that over the 10 years ending August 2020, a portfolio of the so-called FAANG stocks – Facebook, Amazon, Apple, Netflix (number 21 on the list as of 9/29) and Google’s parent company, Alphabet – held in proportion to their market caps would have delivered an average annual return of more than 34% a year, more than twice the 15.2% return of the index (the return of which was boosted by the performance of the FAANG stocks).

Expected versus unexpected returns

How should investors think about the exceptional performance of the FAANG stocks? As Professor Ken French explains: “Stock returns are explained by the expected return and the unexpected return. The expected return is the best guess of what will happen based on all the information currently available. The unexpected return is the surprise, the difference between what does happen and what was expected. Investors should base their portfolio decisions on expected future returns, not recent realized returns, and the two can differ by a lot.”

Clearly, 10 years ago investors were not expecting 35% returns from the FAANG stocks. Those returns were realized because realized results were much better than investors expected – the unexpected (unpredictable) good news produced those high unexpected stock returns over the last decade. However, investors should not expect high unexpected returns to persist because the expected value of the unexpected returns must be zero.

We now turn to the issue of concentration.